The Basics of New-Keynesian Economics

Javier Garcı́a-Cicco

September, 2009

1 Introduction
There is significant documented evidence indicating that, on the one hand, monetary policy is neutral
in the long run and that, on the other hand, there is an apparent negative relationship between inflation
and output in the short run, so monetary policy may have short run real effects. However, models
based on a flexible price assumption fail to replicate one of these two facts. Consider, for instance, a
model with flexible prices and money in the utility function. It is easy to see that in such a model,
if preferences are separable in the holdings of real balances, money is neutral both in the long and in
the short run. Therefore, it seems that one way of obtaining a model aimed to analyze the role that
monetary policy may have in the short run is to depart from the flexible price assumption.
In these notes we present a simple framework that allow us to consider the possibility of prices
being “sticky” in the short run, and in which monetary policy may have a role to stabilize the economy.
Although the model is relatively simple, it will contain the main channels through which monetary
policy can have a short run impact.
The model we will study has been known as a the New Keynesian framework, and of course it
shares many insight with the typical Keynesian IS-LM model that can be found in many introductory
and intermediate macro textbooks. However, an important difference with this original model is that
the New Keynesian literature has recognized that expectations about the future, particularly about
monetary policy, will have non trivial effects. As a historical note, this relevant feature was absent
in the original IS-LM framework,1 and it was this flaw that lead many economist to reconsider its
foundations and to show how this omission may lead to misleading policy recommendations.
The remainder of this document is organized as follows: section 2 presents the details of the model
and derives the two main equations characterizing the equilibrium, while section 3 analyzes the optimal
monetary policy in this framework. Section 4 concludes.

2 A Simple Model of Price Rigidities

We will consider a closed economy, populated by infinitely lived households that consume, save and
work, and by two types of firms: a large number of intermediate goods producers, each of them
having monopoly power, and competitive firms that bundle these intermediate goods producing the
final consumption good demanded by households. In addition, there is a government that controls
monetary policy. Price rigidities are introduced by assuming that firms are allowed to change prices
1
And it is still absent in most modern introductory and intermediate macro textbooks.

1
randomly, so only a fraction of firms will be able to select their prices optimally in each period. Notice
why we need to assume some sort of monopoly power: under perfect competition firms take prices as
given and, therefore, frictions in price settings cannot be consider in such an environment.

2.1 Households
The representative household derives utility from consumption of final goods and leisure, and seeks to
maximize expected discounted utility given by
(∞ )
X  C 1−σ
t t
E0 β − Lt ,
1−σ
t=0

where Ct denotes consumption and Lt is hours worked. They have access to a nominal bond (Bt ) that
pays a gross nominal rate It , which allows them to transfer resources over time. In addition, they
receive wages (Wt ) and the stream of nominal profits from monopolistic firms (Qt ) (i.e. households
are the owners of this firms). However, these profits are taken as given in the maximization process.
The period t budget constrain is then

Pt Ct + Bt = Wt Lt + Bt−1 It−1 + Qt ,

where Pt is the price of final goods, which will be our measure of the price level. The optimality
conditions associated with the problem of choosing Ct , Bt and Lt to maximize expected utility subject
to the sequence of budget constrains (and taking prices as given) include the budget constraint, a
transversality condition, and ( )
−σ
σ Wt −σ Ct+1
Ct = , Ct = βIt Et , (1)
Pt Πt+1

where Πt ≡ Pt /Pt−1 is the gross inflation rate.

It will be convenient to re-write these expressions in terms of the logs of the variables, for which
we will use the following notational convention: for a given variable Zt , we will use its lowercase
counterpart to denote its log, i.e zt ≡ log(Zt ). Therefore, applying log’s to equations (1) we get,

σct = wt − pt , (2)

and2
−σct = log(β) + it − σEt {ct+1 } − Et {πt+1 }.

Denoting ρ ≡ − log(β), the second equation becomes

ct = Et {ct+1 } − σ −1 (it − Et {πt+1 } − ρ) (3)

2
As a technical detail, it may appear that we are making an algebraic mistake in this expression, because we are
placing the log operator inside the expectation, which is clearly not valid due to Jensen’s inequality. However, we can
think this expression as a first-order Taylor expansion of the original equation, and in that case this expression is only
an approximation of the original Euler condition. Whether such an approximation is accurate or note will depend on
the particular problem at hand, but we will use it anyway for it simplifies significantly the exposition of the model and
allow us to better understand the intuition.

2
The term it − Et {πt } is the the real interest rate. Therefore what equation (3) says is that the
relevant variable that determines the intertemporal choice of consumption is this real interest rate.
Equation (2), on the other hand, establishes that the marginal rate of substitution between labor
and consumption must equal the real wage; however, because utility is linear in L, this relationship
depends on consumption only.

2.2 Final Goods Producers

The final good consumed by households is produced by a competitive firm (i.e., that takes prices as
given) who combines a large number N of intermediate goods (or varieties), each of them denoted by
the index j. In particular, the technology used to bundled these intermediate goods is
  ǫ
N ǫ−1
X
1−1/ǫ
Yt =  (Xj,t )  . (4)
j=0

Here ǫ > 1 is the elasticity of substitution between different varieties,3 and Xj,t is the quantity
demanded of good j. This firm sells at a price Pt and each variety has a price Pj,t and will choose Xj,t
for j = 1, ..., N to maximize profits, i.e.
  ǫ
N ǫ−1 N
X X
1−1/ǫ 
max Pt  (Xj,t ) − Pj,t Xj,t . (5)
{Xj,t }N
j=1 j=0 j=0

In principle, in maximizing profits, this firm should chose its demand for the N intermediate goods
(i.e. Xj,t for j = 1, ..., N ), and therefore we should have N first-order conditions. However, given the
symmetry associated with that the CES function, it is enough to characterize the first order condition
with respect to a generic Xj,t , which yields
  ǫ −1
N ǫ−1
X
1−1/ǫ
Pt  (Xj,t )  (Xj,t )−1/ǫ = Pj,t , for j = 1, ..., N.
j=0

ǫ−1
In order to simplify this expression, notice that we can write (4) as Yt ǫ = N 1−1/ǫ . Thus,
P
j=0 (Xj,t )
ǫ ǫ−1 ǫ 1
the expression [ N 1−1/ǫ ] ǫ−1 −1 can be written as (Y ǫ ) ǫ−1 −1 = Y ǫ . Therefore, we can rewrite
P
j=0 (Xj,t ) t t
the first order condition as
Pj,t −ǫ
 
Xj,t = Yt . (6)
Pt
This equation shows the demand for the intermediate good j which, as normal demand functions,
depends negatively on its own price and increases with change in aggregate demand Yt .
3
This type of function is known as CES (constant elasticity of substitution), exactly because this elasticity is the same
for all varieties.

3
2.3 Intermediate Goods Producers
Each firm producing a type of intermediate good has available a technology that uses labor to produce
according to
Yj,t = At Lj,t ,

where At is an exogenous random variable denoting productivity that is the same for all firms. Notice
that because of the linearity in the production function, the nominal marginal cost (i.e. the cost of
producing one additional unit) is
M Cj,t = Wt /At , (7)

which is the same across firms, so we can drop the subindex j.

These firms have monopoly power and face a demand given by (6). Once they set prices, they
produce the amount implied by the demand, so that Xj,t = Yj,t . Therefore, their profits can be written
as
Pj,t −ǫ
 
(Pj,t − M Ct ) Yt ,
Pt
and their goal is to choose Pj,t to maximize this profit, taking everything else as given.
We will first analyze what would this firm choose in the hypothetical case of no price rigidities,
which we will denote by Pt∗ .4 This hypothetical situation is sometimes referred as the natural equi-
librium. The optimal choice (i.e. the maximization of profits with respect to Pj,t taking Pt and Yt as
given) in such a situation satisfies the first order condition

(Pt∗ )−ǫ = ǫ(Pt∗ − M Ct ) (Pt∗ )−ǫ−1 ,

which can we simplified to

ǫ
Pt∗ = M Ct .
ǫ−1
This condition establishes that the optimal choice in this hypothetical situation is to set prices as a
ǫ
markup ǫ−1 over nominal marginal costs.5 Expressing this condition in logs we have

p∗t = µ + mct , (8)

where µ ≡ log(ǫ/(ǫ − 1)).

Price rigidities are introduced by assuming that with probability θ firms are not allowed to change
their price.6 Therefore, the problem of a firm that is allowed to choose a price at a given period is
now intertemporal, for there is a chance that the price chosen today will be in place in the future as
well. If firms were allowed to reoptimize in every period (i.e. θ = 0) we know they will choose the
hypothetical price p∗t . However, if this is not the case, we will assume that firms choose the price in
order to minimize the expected distance between the price they will choose, p̄t , and the optimal price
4
Notice that, because marginal costs are the same for all firms, in this case all of them will chose the same price.
5 ǫ
Given that ǫ > 1, ǫ−1 > 1 as well.
6
This way of considering price rigidities is due to Guillermo Calvo (1983).

4
they would have set if prices were flexible. That is, their goal is to choose p̄t to minimize
(∞ )
1 X
s ∗ 2
Et (βθ) (p̄t − pt+s ) .
2
s=0

It is relevant to understand the weights for each of these terms in the sum (βθ)s . On one hand, β s
is the discount factor used by households, which is the relevant discount rate given that we assumed
that firms are owned by them. Additionally, the term θs denotes the probability that s periods from
the current time firms will not have the chance to change its price.7
Differentiating this loss function with respect to p̄t , we obtain
(∞ )
X
s ∗
Et (βθ) (p̄t − pt+s ) = 0,
s=0

or, rearranging,8
(∞ )
X
s
p̄t = (1 − βθ)Et (βθ) (p∗t+s ) . (9)
s=0

This optimality condition indicates that firms set prices in a forward looking way: the optimal price
is the weighted sum of all future hypothetical flexible prices p∗ that they would have chosen in the
absence of price rigidities. In particular, the weights are smaller the further in the future they are
(both because they dislike the future at rate β and because the chance of not being able to reoptimize
decreases with time). In addition, notice that if θ = 0 this condition collapses to p̄t = p∗t , i.e. the price
is exactly the hypothetical flexible price in all periods.
We can further simplify this expression as follows,
(∞ )
X
p̄t = (1 − βθ)p∗t + (1 − βθ)Et (βθ)s (p∗t+s )
s=1
∞
( )
X
= (1 − βθ)p∗t + (1 − βθ)(βθ)Et (βθ)s−1 (p∗t+s )
s=1
∞
( )
X
= (1 − βθ)p∗t + (1 − βθ)(βθ)Et (βθ) s
(p∗t+1+s )
s=0
= (1 − βθ)p∗t + (βθ)Et {p̄t+1 }. (10)

where the last step just takes into account the definition of p̄t in (9), but evaluated at t + 1.9 This
expression indicates how prices that are chosen at t evolve over time. However, we would like to have
an expression in terms of the aggregate price level pt . Since the aggregate price is the average of all
7
Notice that this explains why, even though p∗t+s is in this sum, the other term is p̄t and not p̄t+s . This is because we
are considering the choice at period t, so we need to see where p̄t is in the infinite sum, which is exactly in those states
of the future in which it never had the chance to reset prices.
8 P i
It will be useful to notice what is the solution of a generic geometric series S = ∞ i=0 a , where |a| < 1. Notice that
2 2 1
S = 1 + a + a + ..., or equivalently S = 1 + a(1 + a + a + ...) = 1 + aS. Thus, we have that S = 1−a .
9
Notice also in the third step that the initial point of the sum have changed, so actually the second line is the same
as the first one.

5
prices, if the number of goods N is very large, then 1 − θ is the fraction of firms that will set the price
p̄t , while the other fraction θ will have the previous-period price. This is,

pt = (1 − θ)p̄t + θpt−1 . (11)

Using (11) to replace p̄t and p̄t+1 in (10) we get

 
1 θ 1 θ
pt − pt−1 = (1 − βθ)p∗t + (βθ)Et pt+1 − pt ,
1−θ 1−θ 1−θ 1−θ
θ 1
or, noticing that − 1−θ = − 1−θ + 1,

1 1
(pt − pt−1 ) + pt−1 = (1 − βθ)p∗t + (βθ) Et {pt+1 − pt } + (βθ)pt ,
1−θ 1−θ
or, subtracting pt on both sides,

1 1
(pt − pt−1 ) − (pt − pt−1 ) = (1 − βθ)p∗t + (βθ) Et {pt+1 − pt } − (1 − βθ)pt .
1−θ 1−θ
Finally, defining πt ≡ pt − pt−1 to denote the inflation rate, we get

θ 1
πt = (1 − βθ)(p∗t − pt ) + (βθ) Et {πt+1 },
1−θ 1−θ
or
πt = κ(p∗t − pt ) + βEt {πt+1 }, (12)

with κ ≡ (1−θ)(1−βθ)
θ . Therefore, inflation depends, on one hand, on the difference between the current
price level and the hypothetical flexible price level and, on the other hand, on expected inflation. This
second term is relevant because it indicates that inflation is forward looking and agents’ expectations
about the future, particularly about monetary policy, will affect current events.

2.4 Equilibrium and Gaps

Because this is a closed economy, in equilibrium we will have yt = ct and bt = 0. The goal now is to
express the term (p∗t − pt ) in (12) as a function of something that we will call the output gap. We can
subtract p∗t in both sides of equation (8) to get

p∗t − pt = µ + rmct ,

where rmct ≡ mct −pt is the real marginal cost. Notice that in a hypothetical flexible price equilibrium,
(8) says that the real marginal cost rmc∗t would equal −µ. Therefore, the difference between the
hypothetical flexible price and the aggregate price in the equilibrium with price rigidities is p∗t − pt =
rmct − rmc∗t . Therefore we need to get an expression for real marginal prices in both situations. Using
(7) in logs we can write
rmct = wt − pt − at ,

6
which, using (2) and the fact that yt = ct in equilibrium, yields

rmct = σyt − at .

Similarly, in the hypothetical flexible price we would have rmc∗t = σyt∗ − at .10 Therefore, we can write
p∗t − pt = σ(yt − yt∗ ) ≡ σxt , where xt is defined as the output gap. Equation (12) then becomes

πt = γxt + βEt {πt+1 }, (13)

with γ ≡ κσ. This equation is known as the New-Keynesian Phillips curve (NKPC). We already
discussed one important implication of this equilibrium relationship: inflation is a forward looking
phenomena. Additionally, now we can see that the relevant measure of activity that affects inflation is
the output gap. Therefore, notice that it is not just output what determines the dynamics of inflation,
nor is a simple deviation of output from a trend, what matters is the difference between actual and
natural output (i.e the hypothetical output that would have occurred without price rigidities).
To get additional intuition on this relationship, assume for a moment that expectations about
future inflation are given. In this case, the NKPC says that inflation will rise when output is higher
than what it should be in a situation with no price rigidities. Therefore, it is not always the case
that any shock that increases output will put upward pressure to inflation, it will only do so if output
is increasing over its natural level. However, the NKPC implies more than that. Note that because
equation (13) is valid for all t, we can use it to write what will be inflation in t + 1 and replace in the
right hand side. This exercise, called forward iteration, yields11

πt = γxt + βEt {πt+1 } = γxt + βEt {γxt+1 } + β 2 Et {πt+2 }

= γxt + βEt {γxt+1 } + β 2 Et {γxt+2 } + β 3 Et {πt+3 }
∞
X
= γ β j Et {xt+j }.
j=0

We can then see that inflation does not only depend on the current output gap (as it was generally
assumed in the traditional Phillips Curve specification), but also depends on all its future expected
values.
The final piece that we have to derive is an equation for the evolution of the output gap. The
Euler equation (3), combined with the equilibrium condition yt = ct , yields

yt = Et {yt+1 } − σ −1 (it − Et {πt+1 } − ρ).

In a hypothetical equilibrium with flexible prices, the same relationship will hold with two differences:
yt will be replaced by yt∗ , and the real interest rate it − Et {πt+1 } will be replaced by the one that
would be observed in such an equilibrium, which we will denote by rt∗ (the natural rate of interest).
10
This is because nothing in this last derivation depends on the assumption about price rigidities and therefore it has
to be valid for any equilibrium. In addition, notice that at is the same in both situations because it is an exogenous
variable.
11
In the last line, we have used the assumption that, if the equilibrium is stationary (in the sense that eventually
variables will converge to their long run values), we should have limj→∞ β j Et {πt+j } = 0.

7
Thus, in this hypothetical situation, the Euler equation would be

yt∗ = Et {yt+1
∗
} − σ −1 (rt∗ − ρ).

and, subtracting these two equations, we get

xt = Et {xt+1 } − σ −1 (it − Et {πt+1 } − rt∗ ). (14)

This equation is usually called the Dynamic IS curve (DISC). It indicates that the output gap is also
forward looking and, additionally, that what matters for its determination is the difference between
the observed real interest rate and the natural rate. Notice also that changes in the natural level of the
economy will have an effect in inflation and output gap only through its effect on the natural real rate
of interest (which in general will depend on the real exogenous forces of the model, like technology or
preferences).
Additionally, as we did with the NKPC, we can also iterate forward the DISC to obtain,12

xt = Et {xt+1 } − σ −1 (it − Et {πt+1 } − rt∗ )

= −σ −1 (it − Et {πt+1 } − rt∗ ) − σ −1 Et {it+1 − πt+2 − rt+1
∗
} + Et {xt+2 }
X∞
= −σ −1 Et {it+j − πt+j+1 − rt+j∗
}.
j=0

Here we can see how monetary policy may have an impact in the level of economic activity and thus
to be non-neutral: current and future policy actions that affect the nominal interest rate may affect
current output gap. This will happen to the extent that changes in policy are not fully offset by
changes in inflation, which would be the the case if prices were flexible, but that will not occur in
general due to the presence of price rigidities. This equation also allows us to see how expectations
about future policy can affect current economic conditions, for is not only it what matters for the
determination of xt but also all future values of this rate.
Both the NKPC and the DISC, together with a process for the natural rate rt∗ , constitute the
non-policy block of this basic New Keynesian model. Notice how the system has a simple recursive
structure: the NKPC determines inflation given a path for the output gap, while the DISC determines
the output gap as a function of the (exogenous) natural real interest rate and the actual real interest
rate. Of course, we need an additional equation that determines what the nominal interest rate is,
which will come from the description of monetary policy.
Before turning to the policy exercise, it is relevant to notice that so far we have not introduced
money into the model; which might seem odd given that we want to talk about monetary policy. For
the most part in this document we will abstract from modeling a role for money, which will allow
us to better understand how the frictions related with price rigidities affect the economy and what
monetary policy can do to prevent this. Therefore, for the moment we will just assume that the policy
instrument is the nominal interest rate. But in section 3.3 we discuss the implications of bringing back
the demand for money to the picture.
12
In this case, we have also used the assumption of stationarity to impose limj→∞ Et {xt+j } = 0.

8
3 Monetary Policy in the New-Keynesian Framework
We will first analyze what is the optimal policy in this model. In general, optimal policy is defined
as the one that maximizes the welfare of the representative agent. An appropriate benchmark is
then the central planner’s equilibrium, for we know that she will always achieve the Paretto optimal
solution, maximizing welfare. In this model, what a central planner will do is to eliminate the distortion
associated with price rigidities, and therefore arrive to an equilibrium in which prices are fully flexible.13
Given that we have expressed our model in terms of the output gap (xt ), i.e. the difference between the
output in the equilibrium with price rigidities and that under flexible prices, the monetary authority
will be able to replicate the planners equilibrium if it can implement a policy that makes the output
gap equal to zero at all times.
What will be the implications for inflation of the output gap being always zero? From the NKPC,
we have that, if xt = 0, πt = βEt {πt+1 }, so an equilibrium in which the output gap is zero is one with
πt = 0 for all t. How can this goal be achieved? From the DISC we can see that if πt = xt = 0 for all
t, we get it = rtn for all t. Therefore a policy that sets the nominal interest rate equal to the natural
rate at all times can implement an equilibrium with output gap and inflation being zero at all times.
The conclusion is then that the optimal policy in this context prescribes to have full inflation
stabilization. Another way to see why this optimal is to recall that firms do not like to have prices
that differ from the price they would have chosen under flexible prices (p∗t ) but, because they cannot
fully adjust prices due to the probability θ, depending on aggregate economic conditions they will
likely choose a price that is different than p∗t . However, we can show that if inflation is always zero,
firms’ optimal choice will actually be to set p̄t = p∗t whenever they have the chance to do so. To see
this, notice that, from equation (12), if πt = 0 for all t we get pt = p∗t . Additionally, from equation
(11) we get that, because πt = 0 implies pt = pt−1 , we should have p̄t = pt for all t, which verifies that
p̄t = p∗t for all t. In other words, a policy of full inflation stabilization gives firms the incentives to
optimally choose the price that fully eliminates the loses associated with price rigidities.
It is also important to highlight that, although the optimal policy requires xt = 0, it does not
necessarily imply that output (yt ) has to be completely stabilized. In principle, the natural level of
output can fluctuate over time due to all sorts of real shocks (e.g. technology or preference). It follows
that policies stressing output stability (possibly around a smooth trend) may potentially generate
large deviations of output from its natural level and, therefore, be suboptimal.

3.1 Implementing the Optimal Policy

As we saw, the optimal policy can be attained by setting the nominal interest rate such that it = rt∗ for
all t. Although this conclusion is internally logic, as a policy recommendation is somehow useless, for
rt∗ is the real interest that would have prevailed had prices been flexible, which is of course a situation
that we will never observe. An alternative is to consider a simple rule that sets the interest rate as a
function of an observable variable, for instance

it = φπ Et {πt+1 }. (15)
13
Additionally, the planner problem will also differ in that she will want to eliminate monopoly power as well. For
simplicity, we will abstract from this issue.

9
In other words, a rule by which monetary policy adjust to changes in expected inflation. Although to
show how this rule, depending on the value of φπ , will actually allow to stabilize inflation is algebraically
complicated, we can still get the intuition graphically. Replacing the monetary rule into the DISC we
get
xt = Et {xt+1 } − σ −1 (φπ − 1)Et {πt+1 } + σ −1 rt∗ . (16)

Plotting this curve in the plane {xt , πt }, for given values of Et {xt+1 }, Et {πt+1 } and rt∗ , this curve is
just a vertical line, which is depicted in Figure 1 by the curve labeled DISC0 . We can also plot the
relationship between xt and πt implied by the NKPC, for a given value of Et {πt+1 }, which correspond
to the positively-sloped line labeled N KP C0 . The resulting values for inflation and output gap
correspond to point A.
Consider now a sudden increase in inflation expectations Et {πt+1 }. In terms of the NKPC, for
any value of xt , a rise in Et {πt+1 } increases inflation. Therefore, the curve shifts upwards to the line
N KP C1 . What will happen with the DISC? The result will depend on monetary policy. If φπ < 1,
an increase in Et {πt+1 } rises xt , shifting the curve to the right and reaching a situation like B with
higher output gap and inflation. It is clear then that such a rule cannot stabilize inflation: if inflation
is expected to rise, the monetary rule acts in a way that confirms this expectation and, therefore,
inflation may arbitrarily move away from the original equilibrium.

Figure 1: The intuition behind the Taylor Principle

St DISC1 DISC0 DISC1

NKPC1
if IS ! 1 if IS  1
B
NKPC0

C A

xt

If φπ > 1, on the other hand, the DISC curve shifts to the left and, depending on the size of this
shift (i.e. depending on how large is φπ relative to one), we can reach a situation like C with both
inflation and the output gap actually falling. Therefore a sufficiently aggressive response of the nominal
interest rate when expected inflation changes can counteract the effect, and the higher expectation
about inflation will not materialize. Is in this sense that we can argue that this policy can achieve

10
inflation stabilization, for it will act in a way that compensates for fluctuations in expected inflation.
That a sufficiently aggressive response of the policy rate to inflation expectations has stabilizing
properties is what is known as the Taylor Principle (due to John B. Taylor, 1993), and is one of the
most important concepts behind monetary policy actions of central banks that embark in an Inflation
Targeting regime. Such a regime is one with the goal of attaining a predetermined target of inflation
(or maybe for inflation to lie in a predetermined band). Many central banks in both developed and
emerging countries have currently an inflation targeting regime: New Zeeland, England, Norway,
Sweden, Chile, Colombia and Brazil, to name a few, have formal predetermined targets or bands
for inflation, and other countries, although not formally, are argued to follow a goal of inflation
stabilization as well (like the U.S. and the Euro Area).
Finally, it is relevant to notice that equation (15) is not the only rule that can be used to stabilize
inflation. For instance, a rule that reacts to current inflation (it = φπ πt ) or one that reacts to both
current inflation and output (it = φπ πt + φy yt ) will also work, however the intuition is harder to grasp
in this case and a more rigorous analysis is required (a goal that we will not pursue here). However,
it is still relevant to mention that the stabilizing properties of these alternative rule still depend on
how aggressive monetary policy reacts to changes in inflation (actual or expected), and that is why
the Taylor Principle is such an important concept.

3.2 Policy Trade-offs Between Inflation and Output Gap Stabilization

One striking feature of the model we have analyzed so far is that monetary policy can achieve both
inflation and output gap simultaneously. In other words, there is no trade-off between inflation and
output gap stabilization. This is just because of the simplicity of the model we have analyzed, and
additional features we may incorporate could alter this result. Probably the simplest way to obtain
such a trade-off is to include an additional shock in the economy that directly enters the NKPC, i.e.

πt = γxt + βEt {πt+1 } + ut , (17)

where ut is an exogenous shock (sometimes called a cost-push shock or inflation shock) that, for
simplicity, we will assume to be i.i.d. (in particular, that Et {ut+j } = 0 for all j > 1). Notice that the
case we have analyzed before is just a particular case of this new specification when ut = 0 for all t.
Although we are introducing this shock in an ad-hoc fashion it can be rationalized, for instance, as an
exogenous variation in the desired mark-up µ.
To see that this will introduce a trade-off between output and inflation stabilization, consider
trying to fully stabilize output gap by setting xt = 0. With this new version of the NKPC we will get
πt = βEt {πt+1 } + ut . When ut = 0 we have argued before that πt = 0 is a solution for this equation.
However, in the general case when ut is allowed to fluctuate it is not longer true that it is optimal to
set πt = 0 and inflation will fluctuate somehow with changes in ut . Therefore, inflation and output
gap stabilization cannot be simultaneously attained, and it is not straight forward to characterize the
optimal policy in this case.
One possibility to describe the best policy is to postulate a loss function that the monetary authority

11
tries to minimize. In particular, we will consider the goal of choosing πt , xt and it to minimize14
(∞ )
X 1
s 2 2

Et β α(xt+s ) + (πt+s ) ,
2
s=0

subject to equations (16) and (17). The parameter α is the preference for output gap stabilization
relative to inflation stabilization. The Lagrangian for this problem is then
∞ 
X
s 1
α(xt+s )2 + (πt+s )2 + ϕt+s (πt+s − γxt+s − βEt {πt+s+1 } − ut+s ) + ...

Et β
2
s=0
δt+s xt+s − Et {xt+s+1 } + σ −1 (it+s − Et {πt+s+1 } − rt+s
∗
 
) .

where ϕt+s and δt+s are, respectively, the Lagrange multipliers associated with constraints (17) and
(16). Consider first the derivative of the Lagrangian with respect to it+s , which yields σ −1 δt+s = 0
for s ≥ 0. That means that actually equation (16) does not impose a constrain to the loss function
minimization problem. In other words, we can interpret this results as saying that policy can always
compensate for the real shock rt∗ . This is consistent with what we have analyzed in the previous
sections: if rt∗ is the only source of uncertainty, there is no policy trade-off. Therefore, equation (16)
will be useful only to back up what the nominal interest rate will be under the optimal policy.
Imposing δt+s = 0 for s ≥ 0, the remainder first order conditions are

πt+s = −ϕt+s , for s = 0,

πt+s = −ϕt+s + Et+s {βϕt+s+1 }, for s ≥ 1,

αxt+s = γϕt+s , for s ≥ 0.

Notice that the first two equations are the conditions characterizing the choice of πt+s . However,
because πt appears only in the constrain for period s = 0 but not in any other period s, the first order
condition is different for s = 0 than for s ≥ 1.15 Combining the conditions for period s = 0 we get
γ
− πt = xt . (18)
α
Optimal policy then implies that whenever inflation is above target output should be contracted
below its natural level (by rising the interest rate). And how aggressive should this contraction be will
depend positively on the gains in reduced inflation per unit of output (given by γ) and inversely on
the relative weight placed on output loses α. Notice that actually this condition also characterizes the
policy problem in the case analyzed in the previous sections, however in that case the solution was to
set always πt = xt = 0.
In the general case, to get the solution we can use condition (18) to replace xt in the modified
14
Actually, a similar quadratic objective function can be derived by approximating, using a second-order Taylor
expansion, the utility function evaluated at the equilibrium.
15
Actually, this difference between the optimality conditions for s = 0 and s ≥ 1 is the source of the time inconsistency
problem as emphasized, for instance, by Barro and Gordon (1983).

12
NKPC and get,16
γ2
πt = − πt + βEt {πt+1 } + ut ,
α
or
γ2
 
πt 1 + = βEt {πt+1 } + ut ,
α
To obtain the solution, we can use a guess and verify method. In particular, we can postulate that
the solution will have the form πt = Γut , replace this expression in the equation and find the value of
Γ that makes the equation to hold. Replacing the proposed solution we get,

γ2
 
1+ Γut = βΓEt {ut+1 } + ut .
α

Notice that the assumption of ut being i.i.d. implies Et {ut+1 } = 0, thus in order for this equation to
2 −1
 
hold for all possible values of ut we should have Γ = 1 + γα . Therefore, under the optimal policy
inflation is determined by
−1
γ2

πt = 1 + ut ,
α
and, using (18), output gap is
−1
γ2

γ
xt = − 1 + ut .
α α
Several things about this result are worth emphasizing. First, notice than when ut = 0 we obtain
the result derived in the previous sections (i.e. πt = xt = 0). Second, we can clearly see that, in the
general case, the shock ut imposes a trade-off for the optimal policy between inflation and out gap
stabilization (e.g. when ut rises, the optimal policy prescribes to increase inflation and to set output
below the natural level). Third, as we mentioned before, shocks to rt∗ do not have an impact on πt
and xt under the optimal policy, for the monetary authority can always move the interest rate to
compensate for fluctuations in the natural rate of interest (as we analyzed in the previous sections).
Finally, we can characterize how the nominal interest rate should behave to attain the goals of
this optimal policy. Replacing the solutions we have obtained in the DISC we obtain, using again the
assumption Et {ut+1 } = 0 to eliminate the terms Et {xt+1 } and Et {πt+1 },
−1
γ2

γ
− 1+ ut = −σ −1 (it − rt∗ ),
α α
or −1
γ2

γ
it = σ 1 + ut + rt∗ ,
α α
or, using the solution for πt under the optimal policy,
γ
it = σ πt + rt∗ ,
α
16
As a technical detail, this policy that we are going to derive is actually the constrained optimal policy (see Clarida,
Gali, Gertler, 1999), for we are not going to explore the differences arriving from the fact that the first order conditions
are different for s ≥ 1. However, given the assumption of ut being i.i.d., this constrained policy will not differ from the
globally optimal.

13
Compared with the case with ut = 0, when we saw that the optimal interest rate rule was to set
it = rt∗ , here the interest rate should also react to movements in inflation as well. In this sense, the
optimal policy in this general case is also concerned with inflation stabilization.

3.3 Reconsidering Money Demand Frictions

In models with flexible prices and some sort of money demand friction (like money in the utility
function or cash-in-advance models) the optimal policy is characterized by the Friedman Rule, which
postulates that the nominal interest rate should be set equal to zero and which implies that inflation
should be (on average) negative. This is clearly different that what we have characterized in these
notes: in the presence of price rigidities, inflation stabilization is desirable and the nominal interest
rate should move to reach this goal.
If we were to analyze a model with both types of frictions (for instance, if we add a cash-in-advance
constrain to the model developed in section 2), the optimal policy will lie somewhere in between both
prescriptions, and which of the two end up dominating will depend on the parameter values. However,
several studies have documented that, when parameters are estimated to match certain features of
actual data, it seems to be the case that the inflation stabilization goal dominate and, therefore,
the optimal policy is closer to the prescription of using the interest rate actively to compensate for
fluctuations in the economy rather just setting it equal to zero as prescribed by the Friedman rule.

4 Conclusions
These notes present a basic model to understand the role of price rigidities in determining inflation
and to discuss what should monetary policy do in the short run to “smooth” shocks that hit the econ-
omy, which is the base of the New Keynesian framework. Several conclusions should be emphasized.
First, the presence of price rigidities makes inflation a forward looking phenomena. In particular,
expectations about the conduct of monetary policy in the future, and not only in the present, will
affect current events.
A second relevant point is that inflation stabilization appears to be a robust goal for monetary
policy if price rigidities are the relevant frictions affecting the economy, a prescription that in sharp
contrast with the Friedman rule that can be derived in flexible-price models. Third, we have also
described how a central bank that reacts strongly enough to perceived changes in inflation can stabilize
inflation (the Taylor Principle). Moreover, we have argued that this principle is one of the fundamental
pillars behind inflation targeting regimes that have been in place in many countries since the 1990’s.
Finally, we analyzed how achieving the inflation stabilization goal is not always costless, for there
may be some shocks hitting the economy generating a trade-off between inflation and output gap
stabilization.
As a closing comment, here we have tried to keep the model as simple as possible to try to grasp
the intuition behind these results. However, we should mention that most of these messages extend to
generalizations of this model (e.g. considering capital accumulation, opening the economy, including
sticky wages, among many others). In particular, the desirability of inflation stabilization and the
Taylor principle appear to be robust to many model modifications. A good reference describing these
extension and many other topics in the New Keynesian literature is the book by Jordi Gali (2008)

14
References
Barro, Robert J. and David B. Gordon (1983), “A Positive Theory of Monetary Policy in a Natural
Rate Model,” Journal of Political Economy, 91:4, pp. 589-610.

Calvo, Guillermo (1983) “Staggered Prices in a Utility Maximizing Framework,” Journal Monetary
Economics, 12:3, pp. 383-98.

Clarida, Richard, Jordi Gali and Mark Gertler (1999), “The Science of Monetary Policy: A New
Keynesian Perspective,” Journal of Economic Literature, Vol. XXXVII, December, pp. 1661-
1707.

Gali, Jordi (2008), Monetary Policy, Inflation and the Business Cycle, Princeton University Press.

Taylor, John B. (1993), “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conf. Ser.
Public Policy, 39, pp. 195214.

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